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Think Twice About Equity-Indexed Annuities

These may not be the best bets for your mom and dad.

If you've ever heard of equity-indexed annuities (EIAs), there's a good chance you did so from your mom or dad. And there's a good chance they learned about them at a "free seminar." I know that that's how I first heard about them. My dad enjoyed the free meal and the sales pitch (er ... seminar), but told me he was skeptical about the EIA he was being pitched. He understood that this particular EIA would put a cap on his potential gains. Well, it turns out dad may have been more right than he realized.

At allfinancialmatters.com, one blogger offered a similar take on his dad's experience with an EIA pitch. He made a particularly good point: While EIAs are often compared to the S&P 500, with sellers concluding that the EIAs are the better choice, that doesn't seem right. An EIA will often feature gains capped at a certain level, along with the benefit of never losing any money: If the market tanks in a given year, your loss is zero.

The EIA that the blogger used as his example capped investors' gains each year at 10%. Well, given that the S&P 500's average annual return over the long haul is near 10%, including down years, the EIA is already comparing unfavorably. That's because in good years, your gain will be a maximum of just 10%, and not much higher, as can sometimes happen. In 2003, for example, the S&P 500 rose more than 28%! Your gain in the EIA? 10%. In 2006, it rose more than 15%. Your gain in the EIA? 10%.

You might argue that when it plunges, as in 2002, when it fell 22%, your loss would be zero. But remember that the S&P 500's average return of 10% includes those down years. [Note also that while the historic average return is around 10%, that's in no way what you should expect over your investing time frame. You might earn slightly or considerably more or less.]

Sobering dataThe blogger crunched a bunch of numbers, simulating investments in an EIA and the S&P 500 from 1950 onward. He found that the annuity would have returned less than 7% annually, compared to nearly 10.5% for the S&P 500. Ouch!

According to his analysis, the reason why the numbers worked out this way is because of how the market cycles up and down. He found 34 years when the S&P 500 rose more than 10%, but just 13 years with negative returns. As a result, the benefits of avoiding losses within the annuity were outweighed by the loss of return during great years.

Finally, another consideration is fees, which are often charged yearly whether you make money that year or not. If you're looking at EIAs, be sure to look hard at the annual fees, just as you would with a mutual fund. The blog analysis assumed fees of 1.5% for the S&P 500 option, but you can find index funds that are much cheaper. ETFs like SPDR Trust (AMEX:SPY) or Vanguard Total Stock (AMEX:VTI) offer an inexpensive proxy for the broad market.

Learn more and be savvyHere's some good news, though -- there are some great ways to prepare for retirement responsibly. We cover them routinely in our Motley Fool Rule Your Retirement newsletter. I heartily encourage you to take advantage of a free 30-day trial. It's prepared by Robert Brokamp, a smart and witty guy who distills what you need to know into a manageable volume each month. A free trial will give you full access to all past issues, allowing you to gather valuable tips and find out how some folks have retired early and well (and how you can, too). Robert regularly offers recommendations of promising stocks and mutual funds, as well.

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Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian